Profitability Index
Theoretical Background
The profitability index (PI) is a capital budgeting technique that attempts to identify
the relationship between the costs and benefits of a proposed project and, hence is
also referred to as the “benefit-cost ratio” (Brealey, Myers & Allen, 2008).
The formula is defined as:
Profitability Index = Present Value of Future Cash Flows / Initial Investment
The profitability index is seen as an “extension” of the net present value rule and is
primarily used as a tool for ranking and selecting projects or investments when a firm
has limited capital or resources (Mukherjee & Vineeta (1999).
As the profitability index is ratio of cash flows to initial investment, a ratio of 1 is
logically the lowest acceptable measure on the index. If the profitability index is
greater than 1 (PI>1) then the investment will be accepted.
Therefore, the
attractiveness of the proposed project increases as the value of the profitability ratio
increases (Hillier, Grinblatt & Titman, 2008).
Several advantages exist for using the profitability index. Bester (nd) notes that the
profitability index is useful in that it shows whether an investment increases firm
value, accounts for the time value of money, considers all cash flows of the project
and accounts for the risk associated with future cash flows. Furthermore, as stated
above, the profitability index is a particularly useful tool to select and rank projects
when a firm is operating under capital rationing constraints (Hillier, Grinblatt &
Titman, 2008). Lastly, the profitability index generally leads to the same decision as
the NPV technique – that is, if a project has a positive profitability index, the NPV will
also be positive (Brealey, Myers & Allen, 2008).
In contrast, the profitability index may have several shortfalls.
The main
disadvantage as stated by (Brealey, Myers & Allen, 2008), is that the profitability
index may be misleading when comparing mutually exclusive projects. Furthermore,
the profitability index requires an estimate of the cost of capital to be calculated,
which can be a lengthy procedure (Bester, nd).
Empirical Evidence
International Evidence
The empirical literature on the use of capital budgeting techniques has found that in
international countries, the use of the profitability index is limited. The U.S. survey
by Graham and Harvey (2001) found that only 11.87% of firms “almost or always
use” this capital budgeting method, making it the second most unpopular method
used. A similar result is found in the study by Brounen, de Jong and Koedijk (2004)
which determined that in the U.K., Netherlands, Germany and France, 15.87%,
8.16%, 16.07% and 37.74% respectively, of firms use the profitability index.
In
comparison to other more popular techniques such as NPV and IRR, the use of the
profitability index is significantly infrequent.
A study by Ryan and Ryan (2002)
further supports this notion as it found only 21% of U.S. firms used the profitability
index, once again highlighting its limited use as a capital budgeting tool.
South African Evidence
The empirical evidence concluded in South African studies is generally in line with
those results found in international capital budgeting studies. Du Toit and Pienaar
(2005) found that when asked what “primary capital budgeting method” firms use,
the profitability index was not used at all (0%). When asked to identify “all capital
budgeting methods used”, the profitability index was used 11% of the time when
evaluating investments. Correia and Cramer (2008) concluded that only 7.1% firms
“almost or almost always” use the profitability index and was thus classified as the
least favourable method used. Correia and Cramer (2008) concluded that a “lack of
understanding” may lead firms to prefer other methods over the profitability index.
Lastly, in a recent study by Hall and Millard (2010) it was found that only 4.8% of the
firms in the study use the profitability index as a capital budgeting method.
From the above evidence, it can be concluded that the profitability index is not a
preferred or primary capital budgeting method used to evaluate proposed projects.
Its limited use is found to occur in both international and South African studies.
Although it does not appear to play a significant role in the capital budgeting
decision-making process, the profitability index still remains a useful tool for
evaluating investments when a firm faces capital constraints.